Sterling steady despite renewed uncertainty

When we left our desks on Friday, sterling was as strong as it had been all week, helped by reports of progress on Brexit negotiations. Both David Davis and Michel Barnier agreed that they would work to the goal of moving Brexit talks onto trade next month which the market perceived as progress (or at least reason not to be short the pound going into the weekend).

This morning, in complete contrast, sterling is back under pressure after an article in the Sunday Times reported that Theresa May faces a new leadership challenge. According to the paper, 40 Conservative members of Parliament have agreed to sign a letter to of no confidence. That is short of the 48 names required to trigger a formal leadership battle, but nonetheless, it gives the short term speculative market another reason to sell the pound.

In the grand scheme of things, we should know better by now than to get too carried away by headlines in the media. True these are worrying times for UK businesses, but no more so than what we’ve come to expect in recent months. In fact, a quick look at the chart below, shows relatively little change in the sterling trade weighted index over the past year.

Chart 1: UK Trade Weighted Index

Source: Bloomberg / Deutsche Bank

Nevertheless, journalists must write about something and traders need volatility in order to make money.

Looking at the second chart below, volatility continues to remain compressed at close to its lowest level in almost two years. When put into context of Brexit, uncertainty over the conservative party leadership and ambiguity surrounding the outlook for UK monetary policy, such complacency poses a significant risk to sterling.

Chart 2: GBP/USD Volatility

Source: Bloomberg

After raising rates earlier this month, the market isn’t pricing in another hike until August next year. Although the MPC claimed it wasn’t a case of ‘one and done’ the market remains unconvinced. As such, if it transpires that another hike is likely in the first half of next year, sterling would almost certainly get a boost as investors continue their hunt for yield.

In contrast, the political landscape, poses significant downside risk for sterling, particularly in the short term. Every indication that Brexit negotiations are progressing is quickly followed up by another report suggesting the opposite. Although it is still early days, as time passes, the probability of Britain walking away from the EU without a trade deal in place increases. Speaking on the BBC’s Andrew Marr show yesterday, James Dyson (well known for his pro-Brexit views) claimed that Britain will struggle to make any significant progress until the Government shows that it is prepared to walk away without a deal. He also pointed out that Dyson “fell off the cliff” years ago and has been trading with Europe under WTO rules after moving a significant part of the business to Asia. In his view, there is nothing to be feared.

Unsurprisingly, we don’t expect other UK businesses to share the same view and if the Government does conclude that walking away from negotiations empty handed is the best cause of action, sterling is likely to come under heavy pressure. Regular readers will know that this isn’t our core view and for the time being, our forecasts for both GBPUSD and GBPEUR remain unchanged (see pages 4 and 6 of this report).

All that said, the point of this article was never to discuss our view about the direction of sterling in the months ahead. Instead, the aim was to highlight the growing risk of the volatility spring becoming uncoiled. While short volatility structures have been a profitable trading strategy in recent months, there is a growing risk that a sudden change in the status quo will prompt a rethink.

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